Transport, a U.S.based company, is considering expanding its operations into a foreign country.The required investment at Time = 0 is $10 million.The firm forecasts total cash inflows of $4 million per year for 2 years, $6 million for the next 2 years, and then a possible terminal value of $8 million.In addition, due to political risk factors, Chen believes that there is a 50% chance that the gross terminal value will be only $2 million and a 50% chance that it will be $8 million.However, the government of the host country will block 20% of all cash flows.Thus, cash flows that can be repatriated are 80% of those projected.Chen's cost of capital is 15%, but it adds one percentage point to all foreign projects to account for exchange rate risk.Under these conditions, what is the project's NPV?
A)$1.01 million
B)$2.77 million
C)$3.09 million
D)$5.96 million
E)$7.39 million

Question

Quizplus · Accepted Answer

The correct answer is B. The project's NPV is $2.77 million.The project's cash flows are as follows:Year 0: -$10 millionYear 1: $4 million * 0.8 = $3.2 millionYear 2: $4 million * 0.8 = $3.2 millionYear 3: $6 million * 0.8 = $4.8 millionYear 4: $6 million * 0.8 = $4.8 millionYear 5: $8 million * 0.8 * 0.5 = $3.2 millionYear 5: $2 million * 0.8 * 0.5 = $0.8 millionThe project's cost of capital is 15% + 1% = 16%.The project's NPV is calculated as follows:NPV = -10 + 3.2/(1.16^1) + 3.2/(1.16^2) + 4.8/(1.16^3) + 4.8/(1.16^4) + 3.2/(1.16^5) + 0.8/(1.16^5)= $2.77 million